Frontiers in Development Policy: the Role of Macro-Prudential Policies

The devastating impact of the global financial crisis, which consequently turned into a global economic crisis, created a consensus that pre-crisis financial regulation didn’t take the “Big Picture” of the system as a whole sufficiently into account. As a result, according to the views of many, supervisors in many markets “missed the forest for the tress”. In other words, among other mistakes, they did not take into account the macro-prudential aspects of regulation, which was not the focus of many authorities.

Looking ahead, fixing the fragilities in the global financial system is a key priority. For this reason, the World Bank Institute organized a session on “"Frontiers in Development Policy: the Role of Macro-Prudential Policies"” held in conjunction with the 12th Annual Conference of the Global Development Network, “Financing Development in a Post-Crisis World: The Need for a Fresh Look” which took place in Bogotá, Colombia, January 13 to 15, 2011.

This session focused on macro-prudential policies, which relate to the use of prudential tools to promote the stability of the financial system as a whole, not just that of individual institutions. These policies deal with the intersection of the real economy and the financial sector, providing a birds-eye view of the entire system. In our interconnected, interdependent and highly globalized world, these policies will and has become increasingly important, both in steering the global economy out of the crisis, in moving toward new sources of growth, and averting the next financial crisis.

The session provided an introduction to the basics of macro prudential policies, as well as the critical issues currently being discussed in the financial system policymaking circles. The key takeaways are as follows:

The objective of micro-prudential policy is the protection of the investor/consumer/depositor, while that of macro-prudential policy is mitigation of systemic risk, which arises from either aggregate weakness of the system or individual failure of systemically important institutions.

There are two key challenges to macro-prudential regulations. The first is that the financial system is a dynamic system, so macro-prudential policies need to be flexible and the macro-prudential regulator would require certain powers to carry out its mandate. The second challenge is that there is a strong bias towards inaction on the part of the regulator because the benefits of action are uncertain and long-term while the costs are visible and upfront. This provides support for the view that the macro-prudential policies should be based more on rules, such as automatic triggers, rather than discretionary implementation.

Regulations are but one pillar of the financial safety net. The other pillar being proper supervision and enforcement. Prudential regulation and control & supervision are two very different activities. They have different tools and different emphasis.

The contribution to the crisis of a lack of macro-systemic prudential approach was clear, but there could have been a simultaneous failure of the micro-prudential regulatory approach and the organizational design of financial regulation. Failure in the latter might indicate a bigger issue which is problems with the decentralized governance and “light supervision” approach, and therefore support for a switch to a more centralized institutional organization of financial regulation. Therefore, there needs to be more discussions around the proper governance and institutional organization of the financial safety net.

The advantages of a more centralized organization of financial regulation are lower bureaucratic costs, economies of scale and scope and lower probability of regulatory arbitrage. While the advantages of a less centralized organization of financial regulation are more efficiency due to specialization and lower concentration of power, offering more checks and balances.

Overall, it would be a serious mistake to assume that all that was lacking were macro-prudential regulations, and that an additional layer of macro-prudential regulations would have prevented the crisis. In particular, there needs to be a serious look at whether all necessary micro-prudential regulations were appropriately put in place and adequately supervised and enforced during the crisis. Otherwise come the next financial storm, we may find the global financial system in another sinking boat even with a macro-prudential umbrella because we failed to plug up all the micro-prudential holes.

There is empirical evidence showing that banks with higher capital reserves were better able to wither the financial crisis in terms of better valuation of their stock. There is also evidence that “higher quality” capital and common equity were favorably regarded by stock market investors. Hence the current emphasis in Basel III on strengthening capital requirements, both in quantity and quality, is broadly appropriate.

Regulation still emphasizes “risk-adjusted” capital, which is subject to internal manipulation and therefore leads to regulatory arbitrage. There needs to put more emphasis on “non risk-adjusted” measures of capital, such as the leverage ratio, especially for large banks. Current plans to introduce a minimum leverage ratio in addition to the risk weighted capital goes in this direction.

Financial liberalization and deregulation are still important for conducive investment climate and long-term economic growth. However, it is important to sequence financial liberation after strengthened regulation and supervision. Otherwise the benefits of financial liberation will be offset by the increased probability of crisis.

Finance is inherently a risky business. Regulation and supervision cannot eliminate crises, but make them less frequent and less costly. Also, for sustained economic growth, the financial sector needs to remain profitable and thrive. Authorities need to be careful not over-regulate and strait-jacket the financial sector, otherwise growth will be curtailed.